The advantages & disadvantage of capm

Written by timothea xi

Share

Tweet

Share

Pin

Email

Despite debate, CAPM may be more helpful than its detractors claim. (Getty Thinkstock)

The Capital Asset Pricing Model was developed in the 1960s and continues to exert an influence today despite criticisms that it does not address realistic market conditions. CAPM provides investors a way to predict the return of an asset for its level of systematic, or market, risk. CAPM rests on a number of assumptions, which allow it to focus on the relationship between return and systematic risk, but therein, too, lies its weakness.

Other People Are Reading

Systematic Risk

The formula for CAPM is expressed as a linear relationship between the return required on an investment, such as a stock, and its systematic risk, where E(ri), or the return required for asset i, equals the risk-free rate of return, Rf, plus the beta value for asset i, times the market premium, or the difference between the expected market rate of return and the risk-free rate of return. This linear relationship is expressed graphically as the Security Market Line, which is a literal line on a graph depicting the relationship between the beta, or market risk, and the asset's expected rate of return. CAPM eliminates unsystematic risk, or the risk that is specific to a firm or industry, so it is a simple, focused approach. It is appealing in its simplicity and essential "reasonableness."

Empirically Testable

CAPM continues to serve as the basis for empirical studies predicting prices of individual assets, despite the inaccuracies it can produce. Since the CAPM was first developed by William Sharpe and his associates, CAPM has been tested, critiqued and tested again empirically by researchers using proxies for the different variables. Proxies are approximate estimates that investors will use to compare against their investment. They might use an index like the S&P 500 to represent the market and monthly rates of the 3-month Treasury Bill to approximate the risk-free rate. Critiques of CAPM have pointed out that stock indexes are poor proxies for CAPM variables; that CAPM does not hold in many situations; CAPM does not predict asset prices well; and other factors such as firm size were more reliable measures of systematic risk. Nonetheless, CAPM remains compelling and its results can be improved through better statistical methods and better proxies.

Better Than Other Methods

Compared to other methods, CAPM may lead to better investment decisions. Weighted average cost of capital (WACC) is another investment analysis tool that can be used as a discount rate when appraising investments, with its own assumption that the investment project does not change either the business risk or the financial risk of the investing organisation. When WACC is relied on as the discount rate (rather than CAPM), it can lead to an incorrect investment decision in that a project may be rejected because its Internal Rate of Return, or measure of the worth of an investment, is less than that of the WACC. However, if CAPM is relied on, the project's IRR lies above the Security Market Line and offers a return greater than that required to offset systematic risk.

Not Viable in Reality

The criticism against CAPM stems in large part because of its assumptions: A number of them do not match real conditions. While certain assumptions appear reasonable, such as the desire for investors to hold diversified portfolios reflective of the stock market as a whole and be compensated for systematic risk, other assumptions are more problematic. Namely, real world capital markets are not perfect, and assets may not be priced correctly. Moreover, most individual investors are not able to borrow at the risk-free rate, and therefore the slope of their Security Market Line will be shallower in reality.

At Odds With Investment Appraisal

Investment appraisal is premised on a long-term time horizon, whereas CAPM assumes a single-period time horizon, i.e. a holding period of one year, that could be taken to be constant over longer periods, but market reality often shows that this is not the case.